Lecture Overview Orientation What projects do we invest in? Estimating a Cost of Capital Hurdle Rate Weighted Average Cost of Capital Estimating Incremental Free Cash flows Time-weighted tools NPV IRR Others Summary2
Where we are in the course The first two modules focused on the building blocks of finance which are common throughout the field. Time Value of Money Bonds and Stocks Risk and Return (e.g. CAPM) Starting this week and for the remainder of the course we will focus more on issues at the firm-level. This week focuses on how managers select the projects a firm should undertake. This is known as “Project Valuation” or3 “Capital Budgeting.”
What Projects Do We Invest In? A firm can be thought of as a collection of projects. We saw earlier in the course that the primary goal of the firm is to maximize shareholder value. Selecting the right projects is the key to maximizing shareholder value. Because of this managers need financial tools to help them evaluate among prospective projects. We call this process, “Capital Budgeting,” as it involves the long-term allocation of a firm’s capital resources.4
What Projects Do We Invest In? In order to decide what to invest in we need three things: A return threshold or hurdle rate The expected incremental cash flows related to the project An analysis to stitch the above two items together5
Return Threshold (Hurdle Rate) We have discussed previously the costs of debt and equity. Cost of debt: Interest rates, Yield to Maturity Yield to Call Cost of equity: The required return that equity holders need to be fairly compensated This was estimated with the “CAPM”6
Return Threshold (Hurdle Rate) Moreover, we know that firms raise their capital through some combination of these instruments. (The details of how they choose such a combination will be discussed in subsequent modules.) A firm that employs Debt (D) and Equity (E), at rates of rd and re, respectively, should be investing in things that (at least) covers these capital costs.7
Weighted Average Cost of Capital (WACC) We can calculate a blended cost that weighs the required returns of each source of capital by their weights. We call this the Weighted Average Cost of Capital (WACC) WACC = rd x Percentage of Debt + re x Percentage of Equity This is often simply written as: rd x D + re x E Note, the cost of debt (rd) should be the after-tax cost of debt, because interest on debt payments are deductable from a firm’s net income.8
Weighted Average Cost of Capital (WACC) Example of the WACC A company has debt of $200 million and equity of $300 million. The after-tax cost of debt is 6% and the cost of equity is 14%. %Debt = $200 million / ($200 million + $300 million) = 40% %Equity = 1 - %Debt = 60% WACC = rd x D + re x E = 6% x 40% + 14% x 60% = 2.4% + 8.4% = 10.8% This means the company must invest in projects that earn at least 10.8% annually, otherwise it is9 destroying value.
Cash Flows The next item we need is an estimate of how much cash our new project is expected to provide over its life-time. The most common way to create an estimate of the cash flow (the cash that will flow-in from our project) is to create pro forma financial statements (income statement, balance sheet, etc.) based on what we think is going to happen over the life of the project. Once created, we can manipulate the financial statements to determine the cash that comes in or goes out in a given period.10
Free Cash Flows The cash we are interested in estimating is the cash that will be available to be used to pay our financing (the debt and equity) This is termed the Free Cash Flow (FCF) because we are free to use it to pay for the financing of the project. FCF = Operating Cash Flow – Investment in Operating Capital = (EBIT – Taxes + Depreciation) – (Investment in Fixed Assets + Investment in Working Capital)11
Incremental Cash Flows Note, we are only interested in cash that relates specifically to undertaking this new venture (called the incremental cash flow). For example, if we have already invested in R&D for the project we would not include that amount in our analysis because it has no bearing on our decision to move forward with the project – the money has already been spent (it’s a “sunk” cost).12
Putting these items together Once we know: Our cost of capital (as represented by the WACC) Our estimate of the free cash flows related to the project We can then use these in one of many techniques to make an informed capital budgeting decision. The most common such techniques are the Net Present Value (NPV) and the Internal Rate of Return (IRR). Fortunately, both of these relate directly to our13 Time-Value-of-Money calculations we worked with earlier in the course.
Net Present Value Let’s say we have the following free cash flow projection for a project: Year 0: -$100,000 Year 1: $20,000 Year 2: $25,000 Year 3: $50,000 Year 4: $75,000 Additionally, let’s say the WACC for the company is 9.0%. We can use the TVM analysis to calculate the Present Value of each period and then add them up to get a Net Present Value estimate.14
Net Present Value Year Cash Flow PVIF PV 0 $ (100,000) $ (100,000) Based on this 1 $ 20,000 0.917 $ 18,349 analysis the project 2 $ 25,000 0.842 $ 21,042 should generate 3 $ 50,000 0.772 $ 38,609 4 $ 75,000 0.708 $ 53,132 $31,132 of economic NPV $ 31,132 value in present value terms. WACC 9.00%15
Net Present Value Positive NPV projects (i.e. where the value is greater than zero) create economic value because they pay for their capital costs. Negative NPV projects destroy value because capital costs are not adequately covered.16
Internal Rate of Return While the NPV has an output in dollar terms sometimes it is useful to have a rate (percentage) output from our capital budgeting tool. The IRR analysis is most common for this. The IRR is defined to be the discount rate which produces an NPV of 0. The next slide shows this for our prior example.17
Internal Rate of Return Year Cash Flow PVIF PV In this case the IRR is 0 $(100,000) $ (100,000) 19.63%. 1 $ 20,000 0.836 $ 16,718 We can then compare 2 $ 25,000 0.699 $ 17,467 the IRR to the required 3 $ 50,000 0.584 $ 29,201 hurdle rate (the 4 $ 75,000 0.488 $ 36,613 NPV $ - WACC). When the IRR > WACC IRR 19.63% the project is creating value. When the IRR < WACC the project is destroying value.18
Other Capital Budgeting Tools While the NPV and IRR are the most important and commonly used capital budgeting tools, they are not the only ones. Other common tools include: Payback Period Discounted Payback Period Modified IRR Profitability Index Most frequently, financial analysts will use several of these tools to make an informed view on how to proceed with a project.19
Summary This lecture more formally began our exploration into “Corporate Financial Management” The first step is to determine what projects a firm should choose to undertake. Deciding what to invest in (capital budgeting) involves: Calculating the company’s WACC or relevant cost of capital. Estimating the incremental Free Cash Flows from the project. Using our capital budgeting tools to analytically determine value creation or value destruction:20 NPV, IRR and other tools
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